Securities Fraud Rule 10b-5 Last updated 20 Feb 12

Securities Fraud Action William Rehnquist: When we deal with private actions under Rule 10b-5, we deal with a judicial oak which has grown from little more than a legislative acorn. Blue Chip Stamps v. Manor Drug Stores (US 1975)

Securities Exchange Act of 1934 Section 10 -- Manipulative and Deceptive Devices It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange-- (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Securities Fraud Action Rule 10b-5 Transactional nexus Plaintiff Defendant Elements Procedure Transactional nexus By means of interstate commerce or mails “in connection with purchase or sale”

Securities Fraud Action Rule 10b-5 Transactional nexus Plaintiff Defendant Elements Procedure Plaintiff Purchaser or seller Except in SEC action

Securities Fraud Action Rule 10b-5 Transactional nexus Plaintiff Defendant Elements Procedure Defendant Primary violator (makes statements on which reliance) Includes company statements No aiding & abetting (accts / advisors)

Securities Fraud Action Rule 10b-5 Transactional nexus Plaintiff Defendant Elements Procedure Elements Material misrepresent / omission Scienter – not negligence / knowledge, reckless Reliance – “fraud on market” Causation – must be proved Damages – out-of-pocket

Securities Fraud Action Rule 10b-5 Transactional nexus Plaintiff Defendant Elements Procedure Procedure Statute of limitations (2 yrs + 5 yrs) Special rules for class actions Venue (where company has headquarters) Worldwide service of process Federal discovery rules

Compare to other private actions Exchange Act Securities Act Rule 10b-5 § 18(a) § 9(c) §11 §12(a)(1) §12(a)(2) Fraud icw purchase or sale of security Materially false statement in SEC filing Specified manipu-lative practice (pools, etc) False statement in registration statement Offer or sale of unregistered, non-exempt securities Offer or sale by means of materially false prospectus

Securities Fraud Class Action “when talk is not cheap”

Stanford Class Action Clearinghouse

Stanford Class Action Clearinghouse                                                                                                                                  Federal Securities Fraud Class Action Litigation (lawsuits filed) Pre-Reform Post-Reform Stanford Class Action Clearinghouse

                                                                                                                                

“King of Pain” Curriculum Vitae 1946: born in working-class Pittsburgh                                                                                                                                  “King of Pain” Curriculum Vitae 1946: born in working-class Pittsburgh 1970: U Pittsburgh law grad 1976: joins Milberg Weiss (San Diego) 2004: moves to Lerach Coughlin Stoia Geller Rudman & Robbins (San Diego) 2005: $7.2 billion recovery in Enron litigation ($45 over career) 2007: pleads guilty to obstruction of justice (later Milberg Weiss) 2009: disbarred by California State Bar 2010: released from prison / “Circle of Greed” published “Loathed because he's so mean, feared because he's so powerful, Bill Lerach is the lawyer everyone in Silicon Valley hates.” Fortune Magazine, Sep. 2000 “"In 10 or 15 years you will be holding another hearing about a debacle in the securities market that will make you remember the S&L mess with fondness." Bill Lerach, congressional testimony (1995)

Investigate corporate disclosures …                                                                                                                                  Investigate corporate disclosures …

Who can be sued … Press Release: The company is today announcing its year-end financial results, which continue to look favorable. * * * Auditor no mention that financials are not audited no mention of auditor, which had advised that financials actually “NOT favorable” Lawyer no mention of lawyer who helped draft the press release no “noisy withdrawal” by lawyer

Identify corporate “fiction” …                                                                                                                                  Identify corporate “fiction” …

2d and 3d Circuits - Motive and opportunity Concrete personal benefit Insider trading

1st, 5th, 6th, 10th, 11th Circuits Strong inference of scienter M&O is external marker Unusual insider trading

9th Circuit “Deliberate recklessness” Intentional misconduct

Tellabs, Inc. v. Makor Issues & Rights, Ltd. (US 2007) … PSLRA strong inference of state of mind (scienter) means … “a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference.” … allegations must also be considered “holistically” [isolated insider sales not enough, must have unusual, broad sales] “omissions and ambiguities [in the plaintiffs’ allegations] count against inferring scienter” [discount confidential witnesses] Ruth Bader Ginsburg (civil rights lawyer)

… followed by “surprise”                                                                                                                                  … followed by “surprise”

… resulting in “price drop”                                                                                                                                  … resulting in “price drop”

Basic Inc v. Levinson (US 1988) Timeline The lies 10/21/77: news interview that “no reason for stock activity and no negotiations” 9/25/78: response to NYSE inquiry that “management unaware of development” 11/6/78: Quarterly report that “unaware of any developments” The truth 12/18/78: announce tender offer by Combustion

Efficient Capital Market Hypothesis

Basic Inc v. Levinson (US 1988) “… in open and developed securities market .. Misleading statement defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.” “… reliance is an element of a Rule 10b-5 cause of action. “Presumptions typically serve to assist courts in managing circumstances in which direct proof for one reason or another is rendered difficult.” How can presumption be overcome? Justice Harry Blackmun [MN lawyer]

Basic Inc v. Levinson (US 1988) “… I fear that the Court’s decision may have many adverse, unintended effects as it is applied and interpreted in the years to come.” “… Court assumes buyers and sellers rely on the “integrity of the market price … which most mystifies me.” Justice Byron White [former football player]

Big vs small companies Small companies Big companies Less publicized Fewer analysts No SEC interest Smaller total damages Big companies Public disclosure Many analysts SEC investigation Large damages

Identify “scienter” – such as …                                                                                                                                  Identify “scienter” – such as …

Plead “scienter” … PSLRA [Exchange Act 21D(b)(1)]                                                                                                                                  Plead “scienter” … PSLRA [Exchange Act 21D(b)(1)] In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

                                                                                                                                 File a complaint (e.g. Bay Networks, Inc)

Complaint must tell “fraud” story …                                                                                                                                  Complaint must tell “fraud” story …

… to withstand “motion to dismiss”                                                                                                                                  … to withstand “motion to dismiss”

If so, start settlement negotiations …                                                                                                                                  If so, start settlement negotiations …

Settlement with “corporation”                                                                                                                                  Settlement with “corporation” Buying shareholders (plaintiffs) Payment Corporation Usually nominal payments Insider trading Corporate execs (D&O insurance)

Settlement with “corporation”                                                                                                                                  Settlement with “corporation” Buying shareholders (plaintiffs) Holding shareholders (losers!) Payment Subsidy Corporation Usually nominal payments Insider trading Corporate execs (D&O insurance)

Settlement with “corporation”                                                                                                                                  Settlement with “corporation” Selling shareholders (windfall winners!) Buying shareholders (plaintiffs) Holding shareholders (losers!) Payment Subsidy Corporation Usually nominal payments Insider trading Corporate execs (D&O insurance)

"Index Funds and Securities Fraud Litigation" (Booth) SFCA doesn’t make sense Most investors are diversified SFCA settlement : holders effectively pay buyers Because of circularity: stock price declines on SFCA filing Consider index fund almost always loses more than it gains when SFCA index funds should oppose SFCA Capturing deterrent effect w/o SFCA might be more securities fraud Solution: corporation itself claim – against the individual wrongdoers subject of a derivative action for the benefit of the corporation – and thus all of the stockholders constitute a significant deterrent to fraud Procedure rules of civil procedure: derivative claim must be resolved before SFCA No SFCA unless certified no other equally good way to litigate Caveat: attorney fees are likely to be higher in class actions than in derivative actions

Sup Ct 10(b) jurisprudence 1970s / 1980s 2000s Gr Transactional No privity Zandford A Plaintiff Blue Chip Stamps Lead plaintiff* B Defendant Central Bank Stoneridge C Elements (1) Materiality Basic Bespeaks caution* (2) Misrep Va Bankshares (3) Scienter Ernst & Ernst Tellabs / reckless* (4) Reliance Affiliated Ute / Basic Rebut presumption* (5) Causation/$ --- Dura / circularity* Procedural (1) S/L Gilbertson / Huddleston SOX / Reynolds (2) Federal/state Santa Fe Dabit (3) Arbitration Shearson/Am Express FINRA / D-F* * open questions

Mechanics of Class Action Class Counsel Functions                                                                                                                                  Mechanics of Class Action Class Counsel Functions Get started identify material corporate misrepresentations find appropriate shareholders to act as class representatives file a complaint in a court of class counsel’s choosing Take care of legalities defend the complaint against motion to dismiss (on legal grounds) urge the judge to grant class action status to the litigation send notice to class members, giving them an option to withdraw from the lawsuit undertake discovery of information from the company and other sources Close the deal enter into settlement negotiations with company officials champion any settlement before the judge administer settlement funds appeal any adverse decisions by the trial court judge

Mechanics of Class Action Class Counsel Functions                                                                                                                                  Mechanics of Class Action Class Counsel Functions Get started identify material corporate misrepresentations find appropriate shareholders to act as class representatives file a complaint in a court of class counsel’s choosing Take care of legalities defend the complaint against motion to dismiss (on legal grounds) urge the judge to grant class action status to the litigation send notice to class members, giving them an option to withdraw from the lawsuit undertake discovery of information from the company and other sources Close the deal enter into settlement negotiations with company officials champion any settlement before the judge administer settlement funds appeal any adverse decisions by the trial court judge

Mechanics of Class Action Class Counsel Functions                                                                                                                                  Mechanics of Class Action Class Counsel Functions Get started identify material corporate misrepresentations find appropriate shareholders to act as class representatives file a complaint in a court of class counsel’s choosing Take care of legalities defend the complaint against motion to dismiss (on legal grounds) urge the judge to grant class action status to the litigation send notice to class members, giving them an option to withdraw from the lawsuit undertake discovery of information from the company and other sources Close the deal enter into settlement negotiations with company officials champion any settlement before the judge administer settlement funds appeal any adverse decisions by the trial court judge